Matcap & smooth shading in Blender 2.71 very blocky v. 2.69
In your case this is caused by having Auto Smooth enabled.



From the wiki:


  Angles on the model that are smaller than the angle specified in the Angle button will be smoothed


The Angle slider is used to control how rounded a surface may be before it is split by a hard edge. Edges with an angle greater than this value have their vertex normals split, causing it to appear as a sharp edge instead of a smooth one.



From top-left to bottom-right: Auto Smooth off; On with 180 degree angle; 20 degrees; 10 degrees.

Note that Auto Smooth has no effect on flat-shaded geometry.



Another cause for this could have been the Edge Split modifier. It works similarly to Auto Smooth, except that it does not modify the vertex normals, instead it physically splits the sharp edges into two separate edges.

There is no visual difference between Auto Smooth and the Edge Split modifier, but the modifier affects the rest of the modifier stack and also may be applied.

In your case this is an undesired effect, but if you did want to use this function it's worth noting that Auto Smooth will give you much faster viewport and render performance, since the modifier is physically changing geometry and working with the rest of the stack as opposed to simply adjusting the vertex normals.